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Finance 1, The Notes in the Annual Report: Part VI of "Learnin's From My MBA" Series

About 6 weeks ago, we started a series called " Learnin's From My MBA." The series was meant to help me take the business concepts I had learned in my MBA program and present them to you, an audience of scientists with very little business background.

So far, we've discussed all the major financial statements in the Annual Report. We've also discussed some of the more qualitative aspects of the report by dissecting a "President's Message."

This week, we take a look at the Notes accompanying the financial statements. These are the explanations for the nonstandard parts of the three financial statements we have already looked at. If you're just starting this series, you should probably go back to the first installment and do them in order. The series is meant to be cumulative, and this week's segment in particular will not make any sense until you've at least understood some of the basic workings of the three standard financial statements: the balance sheet, income statement, and statement of cash flow.

As usual, we'll be using a real company as an example -- Alta Genetics, a small Canadian biotech firm. This series is designed for readers to work along with the information here, by downloading and following from their copies of the Annual Report. However, unlike the other parts of this series, where we looked at each line item and what it meant, today we're going to look only at some of the more typical Notes.

The Notes that accompany the financial statements are somewhat like footnotes: They give additional information in instances where you wouldn't be able to understand what the numbers meant with just the description offered. For example, the line item "Cash" on the balance sheet has a very specific meaning: It's the cash the company has, either in the bank or under its mattress. However, line items such as"amortization" are less clear. How is this company amortizing its assets? If it bought, for example, a new centrifuge this year, is it counting on the equipment lasting 5 years or 20? This will mean a big difference in the perceived health of the firm (as seen in the financial statements) -- If the equipment is all being amortized over 20 years and will likely be obsolete in 5, you (the reader) want to know about that.

The Notes section explains these non-self-explanatory line items. Because each Annual Report will have all sorts of these items, the Notes section varies more, content-wise, than any other section does. What we'll be discussing today will be the more "typical" atypical items, if you will.So here we go!

Note 1: Significant Accounting Policies

You'll have a Note much like this one in every Annual Report: It specifies the accounting policies behind the numbers in the financial reports. Some typical accounting policies, and what they mean, are listed below:

Principles of Consolidation

This is the first accounting policy that the Notes explain. When a company owns a bunch of other companies, these principles explain which ones are accounted for in this Annual Report. That is, if your transgenic mouse company owns a separate company that does only animal shipping, the principles of consolidation explain whether the shipping company's earnings, expenses, and other financial information are incorporated in the numbers shown in this Annual Report, or whether they're separate and shown somewhere else.

Inventory Valuation

The inventory valuation accounting policy explains how the company's inventories are calculated. The reason for a special Note on this subject is that there are many different ways of valuing inventory. For example, does the number here reflect the price the company paid for the items;the amount they're worth if it had to sell them "as is"; or the amount the company can sell its inventory for at the retail price of its own product? This Note explains which method was used.

Amortization

Amortization is the third important accounting policy. It deals with the "expensing" of fixed assets (or items) as they get old. The value assigned to the assets of a company has a lot to do with how they are depreciated over time. The amortization schedulein the Alta Genetics' Annual Report shows some fairly standard amortization practices: Buildings are amortized 5-10% per year, furniture 20-30%, and company cars 30%.

Note 3: Inventories

This Note details exactly what inventories are accounted for in the other statements. This gives the reader a better idea of the inventory's actual worth.

In today's example, inventories are broken down primarily because of the unusually high level of inventory on the books: The company wants to show that it is not just adding inventory to make the company look like it's worth more money, and that a large majority of this inventory is in the form of final product, from "proven animals" - goods that can be sold soon.

Note 5: Investment Tax Credits

This whole line item is a predominantly Canadian phenomenon. However, it's one that you'll see in just about any Canadian scientific company. The government of Canada, in its wisdom, gives tax credits to companies doing research. This Note simply points out when these tax credits can be used, when they expire, and how much can be used in each year to come. This is an important section, because the company may look better now than it will in 2 years: Knowing when these tax credits run out is often fundamental for knowing how well the company will do in the years to come.

Note 6: Capital Assets

The Capital Asset Note is quite simply an elaboration of the capital asset line item from the balance sheet. There, all the company's capital assets were in one line. Here, that line is expanded into several different categories, enabling the reader to understand how much of the capital assets is in buildings, how much in land, etc. Also included here is the total accumulated amortization over time - giving the reader an idea of how old these buildings really are.

Note 7: Other Assets

The balance sheet in our example had a really big line item called "other assets". Usually, a miscellaneous category like "other" has a fairly insignificant monetary figure allocated to it -- if youhave a lot of 'it, you create a special line item(like "Centrifuges").

This company had a lot of "other stuff," which is explained here. Two of the other items deserve a special look: Goodwill and Patents.

Goodwill

Goodwill is a bit of an accounting "cheat" - it's the difference between the "book value" of an acquired company and what was paid for it. So, if Alta Genetics bought a company for $2 million and the 'value' of the firm, according to its Annual Report, was $1.5 million, the extra $500,000 paid would be called goodwill (since every accounting equation has to balance, and you always get something for your money). In theory, the reason the companyis worth more than its book value is the 'goodwill' the company has acquired through the years it has been in business. In reality, a company is almost never worth exactly what its book value says it's worth. Instead, it is worth whatever someone else will pay for it -- thus, every acquisition will have either a positive or a negative number for goodwill.

Patents

Accounting practices for patents are, well, pretty weird. If the company has done the research itself and patented something, the patent doesn't show up on the books. Zero. Accounting-wise, it's completely worthless. Patents show up on the balance sheet only if you bought them. And, since you always get something for money you spend, it ends up here, in "other assets."

Note 9: Long Term Debt

Here again, all the long-term debt of the company will be laid out, in much more detail than was seen in the balance sheet. This is for the interest of the reader.Analysts and investors often want to know exactly how the long-term debt is designed: When is the principal due? How much interest are you paying on each loan? etc. This Note is simply an expansion of the "long-term debt" line item into much more detail.

Note 11: Share Capital

This Note, again, simply expands the "share capital" line of the balance sheet. Here we see how many shares are outstanding, and the share capital on a per-share basis. It's really for the reader's convenience, since, in our case, most of the information in this Note could be calculated from the rest of the financial statements.

Note 17: Government Assistance

This Note indicates all government support, whether it is in the form of research grants, tax credits, or something else. This government support is "hidden" in the income statement and balance sheet, and many analysts like to take this kind of "artificial revenue" out of the figures so they can compare the company to others on an equal footing, not counting the government support the company is getting. Remember that government support comes and goes, and if you're investing in a company, you want to know how reliant it is on subsidies and grants.

Note 19: Segmented Information

Segmented information is the presentation of the key figures from the three financial statements in a different way. Here, they are presented, separated by business group (European and North American). Some companies show segmentation by product, or by subsidiary. This way, if one product is simply not making money, everyone knows it.

So ends the Notes section of the Annual Report. I hope I gave you a basic idea of what it contains, and how to use it. Next week, we'll be delving into the quantitative stuff again: I'm going to show some of the key calculations to answer important questions about a company's health.